Modes of Payment in Trade Finance

Modes of Payment in Trade Finance

In trade transactions, payments need to be made in a secure and timely manner. When establishing a new relationship, buyers and sellers usually use intermediaries such as banks, to limit risk. The intermediaries can guarantee that payments are made on schedule. As trust develops between a buyer and seller, businesses may switch to cash advances or providing trade credit on open account terms.

Payments in trade finance have varying types of risk: for the importer and the exporter. In this section, we may consider the importer as the buyer and the exporter as the seller.

The four basic modes of payment are: Open account; Documentary collection; Documentary credit; Payment in advance.

 As a business owner, it is important to understand the different risks for each mode of payment, to see which one is most favourable and suitable for your business requirements.

Open Account

In an open account transaction, a seller will despatch their goods to a buyer and send an invoice (and any other customary or required documents) asking for payment or agreement to pay on a specified date. If goods are shipped by sea, the goods are consigned to the buyer and the documents of title will be sent directly to the buyer. If goods are despatched by air, then the goods are consigned directly to the buyer. A set date for payment is given and the buyer remits the necessary funds to the seller as agreed.

Open account arrangements therefore imply a considerable amount of trust being placed on the buyer by the seller. Once goods have been despatched or services delivered, a seller will lose all control over payment, and is reliant on the trustworthiness and creditworthiness of the buyer to pay. Open account trade is common in international trade, with an estimation of over 80 percent of world trade being concluded on open account terms. It is particularly useful in transactions involving regular shipments, where the importer often makes payments at set intervals for goods received during a preceding period. Where necessary, sellers can seek to obtain credit insurance on their overseas debtors and can use an export invoice discounting or factoring facility to accelerate cash flow.

Documentary Credit (DC) or Letter of Credit (L/C)

A documentary credit (also known as a ‘letter of credit’) is basically an undertaking provided by the buyer’s bank, stating that if the seller complies with its various terms and conditions, the bank will guarantee payment in the manner described therein.

If the seller is in a strong bargaining position, but not strong enough to obtain payment in advance, then the next-best payment method is a documentary credit (letter of credit). If the buyer agrees to settlement by documentary credit, it will request the issuance of the credit by its bank. Details of the credit are then advised through the banking system to the seller.

An L/C requires an importer and an exporter, with an issuing bank and potentially a confirming (or advising) bank respectively. The financiers and their creditworthiness are crucial for this type of trade finance. The issuing and confirming bank effectively replaces the guarantee of payment from the buyer, thereby reducing the risk to the supplier. This is called credit enhancement.

An L/C transaction generally occurs as follows:

1.      An importer agrees to buy goods from an exporter – a purchase order (PO) is issued.

2.     The importer will approach an issuing bank (trade financier) which will issue an L/C if the company fulfils the bank’s criteria (e.g. they are creditworthy).

3.     The exporter will work with a confirming bank, who will request that the L/C documents be checked from the issuing bank (of the importer).

4.     The confirming bank will then check the L/C and if the terms are agreeable, the exporter will ship the goods.

5.     The exporter goes on to send the relevant shipping documents to the confirming bank.

6.     Once the confirming bank has examined the shipping documents in strict compliance with the L/C terms from the issuing bank, they will forward these documents to the issuing bank.

7.     Payment is made according to the agreed terms; guaranteed by the issuing bank.

8.     The issuing bank then releases the shipping documents so that the importer can claim the goods that were shipped.

9.     Depending on the terms agreed, the issuing bank then transfers money to the confirming bank who will then transfer the funds onto the exporter.

L/Cs are flexible and versatile instruments. An L/C is universally governed by a set of guidelines known as the Uniform Customs and Practice (UCP 600), which was first produced in the 1930s by the International Chamber of Commerce (ICC).

Documentary Collections (DCs)

A Documentary Collection (DC) differs from a Letter of Credit (LC).

In a documentary collection, a seller will ship or despatch their goods. However, instead of sending the documents direct to the buyer, they will send them via the banking system (remitting Bank), for holding pending payment or acceptance by the buyer.

The remitting bank will then forward these documents to the bank of the importer. The importer’s bank will therefore go ahead to pay the exporter’s bank, which will credit those funds to the exporter.

The role of the banks in documentary collection is purely to present the documents to the buyer, but without the responsibility that they will be honoured by them. The collection contains no guarantee on behalf of the banks, which act only upon the instruction of the seller, but it is nevertheless a demand against the buyer, performed by a collection bank at their domicile, often their own bank. It is, in most cases, but not always, as is shown below, a more secure alternative for the seller, compared to trading on open account payment terms.

The collections are often divided into two main groups:

• Documents against payment (D/P): This is when the bank notifies the buyer that the documents have arrived and requests them to pay the amount as instructed by the seller’s bank.
• Documents against acceptance (D/A): This is when the buyer is requested to accept a term draft (bill of exchange) that accompanies the documents instead of payment. The seller’s risk deteriorates by handing over the documents against a bill of exchange instead of receiving payment. This is dependent on the buyer’s ability to pay the bill at a later stage, thus the seller has lost the advantage of having control of the documents related to the goods.

Documentary Collection is more convenient and more cost-effective than Letters of Credit, and can be useful if the exporter and importer have a good relationship. It is often used if the importer is situated in a politically and economically stable market.

Payment in Advance

With this method of payment, the buyer pays the money in advance. Once the seller is in receipt of the funds, it arranges for the goods to be shipped or despatched.

From the seller’s point of view, receiving payment in advance of the shipment is an ideal situation, as it appears to eliminate all risks associated with non-payment. However, to be certain of payment, attention must be given to how the money is paid to the seller. For example, if payment is made by a cheque issued by an overseas institution, time must be taken for the cheque to clear and to be honoured. Some sellers may accept payment by credit card. In the event that a fraudulent credit card is used, then the seller’s merchant processor may reclaim the money from the seller’s account.

From the buyer’s point of view, payment in advance carries the greatest risk, as it is wholly dependent on the seller shipping the correct goods in accordance with the contract. In addition, payment in advance can create cash-flow problems for the buyer, as they have to wait to receive the goods